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Real Risk of Naked Puts (Part 2)

Trading naked puts (NP) carries significant risk that often goes unnoticed. I left off discussing what it would take for me, as a wealth manager, to trade NPs in a client account.

Merely having clients sign a waiver of responsibility would hardly be enough to placate my conscience into trading their money with undefined risk. Also, with regard to protecting me, they could always say the waiver was signed out of duress. As discussed last time, whatever I did to ensure they would never claim ignorance in retrospect would make for the WORST. SALES. PITCH. EVER.

And because even the “worst sales pitch ever” is no guarantee they would later admit to full understanding of all the risks (imagine a case where amnesia or dementia caused them to not only forget the harrowing discussion we had beforehand but also to reject acknowledgement of how I virtually tried to SCARE THEM OFF from letting me trade NPs in their account), I might have trouble being a part of something like this.

Ideally all wealth managers know the mortifying possibilities and therefore act in accordance with high standards to protect client capital. While this may not be the case, I have always been ambitious with a high motivation to outperform.

Making all this even scarier is that while a huge market crash can force unrealized losses to approach Reg T margin requirements, far less would be required to wipe out accounts with much lower leverage ratios.

None of this is to say that I would never trade NPs for a client but as a wealth manager I would feel a responsibility to protect from the downside even at the sacrifice of assets under management or performance metrics. I have previously opined that no more than 20% of a portfolio should be allocated to short premium strategies. Knowing this were the case would make me feel comfortable.*

A better way to eliminate catastrophic is to be net long puts at all times. This might allow me to allocate more than 20% to the strategy, too.

* I believe part of the reason Regulation D (Rule 505) biases hedge funds toward accepting only accredited investors is to increase probability that capital invested in hedge funds remains a reasonable fraction of total net worth.